Market Monthly

An analysis of the economy andthe markets

September 2012

As we have continued to report over the past several months, recession in the U.S. appears likely, according to leading (and many coincident) indicators we follow, including ISM Manufacturing, The Federal Reserve Board of Philadelphia’s Leading Index of the United States, and the ECRI Weekly Leading Index. Indeed, much of the globe is either in or near recession. Economic indicators are generally coming in below expectations with negative revisions to prior periods. Business investment and new orders for manufacturing and services are plunging. Indeed, even lagging indicators such as GDP show steep deterioration from the end of last year.

While recent ECB measures in Europe to reduce peripheral countries’ interest costs are a significant step in the right direction, the continent will remain mired in recessionary territory for the foreseeable future as structural issues and austerity measures continue to bite. However, the worst of the liquidity crisis appears to be past. The Fed just announced additional quantitative easing measures (QE3) that it hopes will improve employment and boost core inflation expectations (from current deflation concerns), but the economic impact has largely already played out. Fiscal policy remains the primary concern. The U.S. continues to remain vulnerable to adverse shocks, whether from the fiscal cliff, Europe, the Middle East, or elsewhere. Corporate America has taken advantage of record low interest rates to lever up from a low base, leaving it more vulnerable as earnings (and revenue) pressures continue to mount. Companies remain largely unwilling to add workers given the uncertain economic and policy environment in Washington. Consumer real incomes remain quite weak, despite recent upticks, and consumer savings remain low.

Meaningful economic improvement, however, hinges on global policy makers shifting to a pro-growth stance, staunching the European crisis, and the global economic downturn running its course. Housing remains a bright spot as it continues to show progress, but it’s from a very low base and will likely not be enough to avert a recession. However, this has positive long-term implications for the U.S. economy.

Equity Market Strategies

U.S. economic data has generally been below consensus with negative revisions. Recession is likely, and profit margins and earnings should continue to weaken accordingly. The U.S. is very vulnerable to shocks such as the European crisis or Mideast tensions. We therefore favor a more diversified portfolio that offers greater growth and defensive exposure, with strong financial strength and attractive valuations. We believe these companies should outperform in this environment. While equity valuations in general remain attractive on a long-term basis, stocks are vulnerable in the near-term due to economic weakness and external shocks. While Fed quantitative easing should help financial assets temporarily and weaken the dollar, the underlying economic and company fundamentals will remain challenged.

Strengths we see in the Equity Market include:

Higher quality companies reasonably valued on a long-term basis

Federal Reserve is accommodative; QE3 just announced

Housing improving

Numbering among our concerns includes:

Likely recession, earnings at risk

Weak consumer income and savings bode ill for consumption

Exports declining

Cyclical companies at higher risk

Fixed Income Strategies

Spread products remain attractive to Treasury and Agency debentures on a valuation basis but are more susceptible to headline risks. We remain slightly overweight corporate bonds as investors continue to seek yield and the Fed remains accommodative. Based on our forecast of future inflation, Treasury securities now offer negative real yields at several tenors along the term structure. German support for the eurozone bailout fund has dampened concerns and boosted the prospect for risk assets. In addition the recent extension of QE3 will benefit mortgage bonds as the Fed plans to purchase $40 billion of pass-through mortgages per month for the next year.

Our short-term portfolios will be managed long relative to benchmark duration, as we believe the front-end of the yield curve will be anchored by an accommodative monetary policy. However, intermediate- and long-term portfolios will be managed neutral to benchmark duration, due to the potential for headline risks in Europe, the fiscal cliff and political uncertainty. Our portfolio positions will be underweight Treasury exposure versus corporate bond and securitized products; underweight government-related securities in favor of municipal bonds; and overweight select commercial and residential mortgage-backed securities. Our municipal portfolios will be managed long across all mandates as the municipal sector remains extremely attractive.

Strengths we see in the Fixed Income Market include:

Fed on hold until mid-2015

Corporate fundamentals remain satisfactory

Consumer and corporate deleveraging

Growing pressure to reduce government debt/spending

Numbering among our concerns includes:

European economic woes

Fiscal cliff

Large budget deficit

Low absolute yields

Increased shareholder-friendly activity

Our Investment Strategy

The Advisory Solutions Team has decided to remove the tactical underweight to Non-U.S. Developed Equity for all models. We are increasing our recommended allocation to Non-U.S. Developed Equity from 30% of total developed equity to 40%. We are now at our strategic (long-term target) weighting to Non-U.S. Developed Equity. The allocation to U.S. Equity will be reduced from 70% to 60% of total developed equity.

The Advisory Solutions Team has also decided to increase the weighting to International Fixed Income (Hedged) from 0% of total fixed income to 10%. We remain at a tactical underweight to International Fixed Income (long-term target is 20% of total fixed income allocation). We have maintained a tactical underweight to Non-U.S. Developed Equity and an overweight U.S. Equity since January 2009. From January 1, 2009 to August 31, 2012, the Russell 3000 Index has outperformed the Russell Developed ex U.S. Index by 589 basis points annually, and by 2987 basis points on a cumulative basis. With regard to our overall weighting to equity, we remain at our strategic weighting for all models.

The opinions expressed herein are those of Jeffrey J. Schappe, CFA, Chief Market Strategist of Sterling Capital Management, and the Sterling Advisory Solutions Team, and not those of BB&T Corporation or its executives. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Sterling Capital Management LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.

Investment advisory services are available through Sterling Capital Management LLC, a separate subsidiary of BB&T Corporation. Sterling Capital Management LLC manages customized investment portfolios provides asset allocation analysis and offers other investment-related services to affluent individuals and businesses. Securities and other investments held in investment management or investment advisory accounts at Sterling Capital Management LLC are not deposits or other obligations of BB&T Corporation, Branch Banking and Trust Company or any affiliate, are not guaranteed by Branch Banking and Trust Company or any other bank, are not insured by the FDIC or any other government agency, and are subject to investment risk, including possible loss of principal invested.

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